Subprime Daily Briefing, Dec. 7

By Arnold Kling

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There is a lot to digest this Pearl Harbor day. I’ll save the President’s plan for the end.First, fresh from the Sean Taylor funeral, we have America’s headline chaser, Jesse Jackson, writing in the Wall Street Journal.

Many of the victims of aggressive mortgage brokers were single women, seniors on fixed income, young couples, Latinos and African Americans. They live in every neighborhood in every one of our major cities, and elsewhere. In one block alone on West Madison Street in Chicago, every one of the homeowners is in default on their current mortgage terms. In neighborhood after neighborhood in Chicago, foreclosures have soared to more than 50 per square mile.

However, the people who resisted the siren call of subprime mortgages are feeling like victims, also. The Washington Post tells their story.

The agreement has sparked bitterness and anger among those who either sat out the housing boom or endured friends’ snickers when they stuck with a traditional mortgage and a smaller house. To some who watched prices rise out of their reach or who moved to cheaper cities, the agreement looks like a penalty for those who didn’t gamble.

I continue to believe that there are two issues. One issue is the housing market. The other issue is the credit market and the possibility of a liquidity-panic spiral: many financial institutions trying to shore up capital positions and increase liquidity at once, leading them to dump asset-backed securities, lowering the prices of those securities, causing other financial institutions to mark down their holdings and inducing them to try to shore up capital and liquidity, etc. I think that regulators need to be on top of that and they need to find a judicious way to loosen capital requirements. But Brian Wesbury disagrees.

Hedge funds, private equity firms and nonfinancial corporations also have trillions in cash that is already being put to work. Citadel, a hedge fund, bought at-risk loan pools from E*Trade, and increased its investment stake by $2.5 billion. The French parent of CIFG Services Inc., a major bond insurer, injected $1.5 billion of new capital to shore up its balance sheet. Bank of America invested in Countrywide and HSBC brought its high-risk loans back onto its balance sheet.

The only real problem is that these “fixes” are not cheap. Citibank is paying 11% to Abu Dhabi. E*Trade reportedly sold its problem loans to Citadel for 27 cents on the dollar, a price many think is well below the true value. Institutions with cash and capital will make huge profits in this environment, while those without these two things will fight to survive. While not everyone is happy about it, the market is healing itself.

Some say that we can’t risk a spillover of credit problems into the economy as a whole, but that ignores two things. First, outside of housing-related businesses and financial institutions that invested in subprime securities, the economy is in good shape.

I’ve talked before about how Freddie Mac’s charter to buy investment-quality mortgages should have kept it out of trouble. But The Washington Post reports,

federal law prohibits Freddie Mac from buying mortgages that cover more than 80 percent of a home’s value — unless the loan comes with a safety net, such as an insurance policy that would kick in if the borrower defaults.

However, in recent years, Freddie Mac permitted home buyers to borrow all or part of the remaining 20 percent by using second loans, called “piggyback” loans, with no safety net.

As early as 2005, an industry group protested that the practice was designed to get around the law and should be stopped.

That “industry group” of course wanted to keep the high-risk mortgage market to itself. But, still, if Freddie Mac had stayed out, the high-risk market presumably would have been somewhat smaller.

I find it quite ironic that Leland Brendsel, the former chairman of Freddie Mac, who I don’t think would have touched these loans with a ten-foot pole, got pilloried in the press and hounded by OFHEO (the regulatory agency that oversees Fannie and Freddie). Meanwhile, until today, I have not seen anyone go after the incompetence of Freddie Mac’s current management or the failure of OFHEO to keep Freddie within its charter.

Under the ASF framework, subprime borrowers who need assistance are divided into three segments. Borrowers falling into segment one are current on their loan payments and meet credit score thresholds and the amount of equity in their homes indicate that they are likely to be eligible for refinancing opportunities. Servicers of these loans will structure the refinancings to avoid prepayment penalties whenever possible, and the ASF recommends servicers take all reasonable steps to encourage or facilitate refinancing for these borrowers.

Borrowers falling into segment two may be eligible for a fast-track loan modification if they are current on their loans but ineligible to refinance into any available mortgage product because of poor credit scores, low or no equity in their homes or a history of delinquent payments. Borrowers in this category could be offered a loan modification freezing the interest rate at the introductory rate for 5 years. Freezing payments at a level these borrowers have demonstrated they can afford increases the likelihood of avoiding foreclosure in these circumstances, which benefits borrowers and investors alike.

Segment three is comprised of loans where the borrower is not current on loan payments at the existing introductory rate and does not qualify to refinance into any available mortgage product. These borrowers should work with their servicers, who will determine on a loan-by-loan basis without the benefit of a fast-track approach, the appropriate loss mitigation approach, which may include a loan modification such as rate reduction or principal reduction, forbearance, short sale, short payoff or foreclosure.

The Greenlining Institute, a housing advocacy group in California that began raising alarms about subprime loans nearly four years ago, estimated that only 12 percent of all subprime borrowers and only 5 percent of minority homeowners would benefit from the rate freeze. The Center for Responsible Lending, a nonprofit group that supports homeownership, said the freeze would help only about 145,000 people.

Segment one gets to refinance into a suitable fixed-rate loan at current market rates. Segment two gets to keep (for five years, I believe) the teaser rate on their original subprime loan, which conceivably makes this a better deal for segment-two borrowers.

In the interest of expediting the process of refinancing or modifying people’s loans, the mortgage servicers are not going to look at borrower income in doing the segmentation. Instead, they will look at credit scores. So, if you want to be in segment two rather than segment one, you should make sure your credit history is dinged up. If you’re current on all your debt payments, then all you get is an opportunity to refi.

The only thing that segment one gets out of the deal is that they can refi at the original home valuation, so that the lender will ignore subsequent price declines. I wonder whether it means that the lender will ignore inflated appraisals for cash-out refis.

I think that the net impact of the plan is that it adds to the uncertainty about house prices and the housing market. Economists have never had a very good seat at the table in the Bush Administration, and my guess is that they have had little, if any, influence on this policy.

The one player who could make a difference and bring some quality thinking to the policy in the subprime mess is Federal Reserve Chairman Ben Bernanke. I think he needs to take more of a leadership role.

READER COMMENTS

John Thacker

Dec 7 2007 at 9:45am

I think that regulators need to be on top of that and they need to find a judicious way to loosen capital requirements.

Agreed, but I think that the least-painful way to start going about it is to cut dividends first. The markets didn’t punish Freddie Mac or Fannie Mae for cutting dividends (back to pre-2004 levels). WaMu’s dividend, in particular, is pretty enormous right now. But, their CEO says that of all their uses of capital, “I would put at the top of the priority list the cash dividend for our shareholders, who will continue to view that highly.” And Robert Rubin so far is vowing not to cut Citigroup’s dividend either.

Cutting dividends isn’t a great thing, but it is the easiest way to temporarily shore up capital. So long as the banks aren’t doing that, it’s difficult for me to understand why loosening capital requirements is a better idea. Perhaps I don’t understand.

John Thacker

Dec 7 2007 at 9:47am

[T]he mortgage servicers are not going to look at borrower income in doing the segmentation.

Hmm. The New York Times article you linked yesterday directly contradicted this, but you do certainly have more experience with mortgage servicing.

Dec 7 2007 at 12:21pm

I am reading the material from the Securitization Forum.

Typically, lenders would look at income.

Brad

Dec 7 2007 at 12:26pm

Segment 1 is comical. If you got a teaser rate loan, the idea was to get your credit act together within two years so you could refinance under better terms when the loan was scheduled to readjust! Or if you got one of these loans in order to be able to afford a more expensive home, the idea was to pay down enough principle that you could refinance with a traditional loan in two years but without triggering prepayment thresholds! The comical part about segment 1 is that it’s a customer retention program. Even if you’ve played your cards right with these loans, you’re going to have a hard time shopping for the best terms right now. If your loan was packaged and sold, your refi options might not even be what you expected from the company that originated the loan.

Arnold points out that the people who benefit are those borrowers who screwed up enough but not too much. The flip side is that the people who really get screwed are those borrowers that used these loan products responsibly, met their obligations, and now end up with fewer refinancing options than they expected. Steep price declines have taken many of them out of the running for traditional 30-year or 15-year fixed loans.

Dec 8 2007 at 12:35am

Many of the victims of aggressive mortgage brokers were single women, seniors on fixed income, young couples, Latinos and African Americans.

Well, I accept his apology for his previous arrangements that ordered mortgage brokers to aggressively pursue members of minority groups.

But, of course, I’m not the one he should be apologizing to. He should really be apologizing to all the single women, seniors, young couples, Latinos, and African Americans that he victimized.

However, I assume that now he agrees that members of those groups should be protected from predatory mortgage brokers.

In neighborhood after neighborhood in Chicago, foreclosures have soared to more than 50 per square mile.

Good point. In fact, perhaps we should draw lines around such neighborhoods and prevent, or restrict, loans in such areas. Will the Reverend supply the red pencils?

Gary Rogers

Dec 8 2007 at 9:08am

If I were a politician, I think I might propose something like this. It appears to make more sense than what we will get from the greedy financial companies, it shows that I care about the millions of people that are in danger of losing their homes and proves that I am a man of action and will do something about it. To do nothing would be political suicide.

If I were an economist, I would conclude that in the long run it probably will do more harm than good. I would look at the economy and conclude that it is still looking good in spite of the sub-prime situation and will be able to work things out through market forces. It will take time, but is not yet an emergency.

Since I am neither, I just throw out my opinions. I think the sub-prime situation is a symptom of larger ills created by a highly leveraged lifestyle. I believe we have created our own Ponzi scheme that depends on continued growth and increased values or the whole house of cards collapses. The problem includes fiscal irresponsibility by our governments, corporations and individuals; but markets have a way of dealing with the corporate and individual decisions while government policies need to be checked by the voters. In the case of the sub-prime situation it is important for the market to take care of some of this behavior. In the future, if we do not start getting control of government spending the sub-prime problem will going look like small potatoes. However, things have not collapsed yet and if we can bring some responsibility into our spending practices and start paying down some of our debts there is no reason things cannot be very good for a long time. We have an amazing economy but it has its limits.

Jon

Dec 8 2007 at 11:10am

Actually segment 1 is not guaranteed a refinance; they just appear to be more likely to be able to refinance. All this plan really does is provide a quick way for a servicer to identify cases where a mod is in the best interest of the trusts underlying the securities (on average, the best interest to the investors, although not in the best interest of every investor).

If a loan that is almost certainly going to default and modificication can prevent foreclosure (segment II) is modified, that modification is typically allowed under the securitization agreements; however, modifying a loan that could be refinanced would violate the trust agreements because the investors would be better off getting the principal back. Loans from Group I, could be modified if it were later determined they could not refinance, but they are not “slam dunks”.

What this proposal does is merely provide a way to reduce the number of defaults that occur because of lack of resources or efficient methods of identifying loans that should be modified rather than foreclosed upon. Effectively the government got the servicers to “put their heads together” to come up with a better method than each would likely come up with on its own.

Gary Rogers

Dec 8 2007 at 2:35pm

Something else to consider is mortgage insurance, which aparently only pays off if there is a forclosure. Most of the sub-prime loans will have mortgage insurance and the lenders may prefer a foreclosure where the loss is transferred to the insurance company, even though refinancing may be the cheapest overall solution.